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Low risk equity strategies without interest rate sensitivity

Summary

Many low risk equity strategies, e.g. minimum variance strategies, exhibit a negative exposure to changes in interest rates which can be explained by their strong overweight in interest rate sensitive sectors such as utilities. These sector biases are, however, not needed. Indeed, in our most recent paper we give strong empirical evidence of a low risk anomaly in all equity sectors in both developed and emerging markets. The low risk anomaly is also observed in cyclical sectors, not only in defensive sectors, something we believe can be explained by the way active managers tend to operate and build portfolios aiming at out-performing market capitalization indices. We also find that sector-neutral low-risk approaches appear more efficient at generating alpha than non-sector neutral approaches while reducing the exposure to defensive sectors and consequently the interest rate exposure. In this context we show how sector-neutral low risk strategies based on this research that we have introduced in early 2011 show almost no exposure to interest rate changes and are expected to still deliver strong positive alpha even when interest rate raise, unlike what we find for the MSCI Minimum Volatility index which shows negative alpha in such environments. Some of the properties of sector-neutral low risk investing are also highlighted namely the low correlation of sector-neutral low risk alpha with value alpha, momentum alpha and from smaller capitalization alpha, the fact that liquidity and capacity of sector-neutral low risk appears comparable to that of non- sector-neutral risk investing and superior to that from value, momentum and small capitalization factors and finally the fact that sector-neutral low risk investing also comes with almost zero probability of including in the portfolio stocks that may subsequently deliverer the poorest performances.

Evidence of a low risk anomaly in equity sectors

In our most recent paper “Low Risk Anomaly Everywhere: Evidence from Equity Sectors”[1] we give strong empirical evidence of a low risk anomaly in equity sectors in developed and emerging markets with the lowest risk stocks in each activity sector generating higher returns than would be expected given their levels of risk, and the converse outcome for the riskier stocks. We believe this evidence is a likely consequence of the fact that equity analysts and active fund managers tend to specialize in particular sectors and to mainly select stocks from those sectors. Additionally, constraints restricting the deviation of sector weights in active portfolios against their market capitalization benchmarks are often used by active fund managers, in particular by quantitative managers which tend to go as far as being sector neutral. Evidence of this was gathered by consulting with seven heads of research at large international brokerage firms with bases in the U.S., Europe and Asia, how their teams of analysts and those of their clients operate and how their clients tend to build portfolios. According to them the most widespread sector definition used is the 10 sector GICS[2] definition, which is the reason we used that definition of sectors.

Table 1: Alpha in the LVMHV for each sector in the developed and emerging markets. The beta of the long portfolio, invested in the lowest-volatility stocks, and the short portfolio, with the highest-volatility stocks, is also shown. T-stat is estimated at 5% significance level.

In table 1 we show some results found in the paper giving evidence of the low risk anomaly in each sector in both developed and emerging markets. In these historical simulations we started by estimating the historical volatility of each stock in the index universe at the end of each month from the past two years of total returns in local currencies. The stocks in each sector were then ranked by their historical volatility into three portfolios with the same number of stocks. Stocks in each of these three portfolios were then equally-weighted. Over the period of the simulation the portfolios were rebalanced once every month at the start of each month. 

The results in table 1 include the beta of the portfolio strategy invested in the lowest volatility stocks of each sector i, beta (β) i (lowest risk), the beta of the strategy invested in the highest volatility stocks of each sector i, beta (β) i (highest risk)

and the alpha generated from beta neutral long-short portfolio strategy, long the lowest volatility portfolio and short the highest volatility portfolio with ex-post volatility set to 5% over the entire period. We call this long-short portfolio strategy Low Volatility minus High Volatility (LVMHV).

As shown in table 1 the alpha in every sector in both developed and emerging markets is positive. In the paper we also found evidence of the low risk anomaly in sectors in four developed countries and to great extent in four emerging countries. Only when the sample history is short, or not enough stocks are available in a given sector, do we find less strong evidence of the low risk anomaly.

Advantages of sector neutral low risk investing

Sector-neutral low risk investing is about investing in low risk stocks from all sectors rather than almost exclusively in defensive sectors as tends to be the case with minimum variance strategies and almost all other low risk equity investments. As show in table 2 sector-neutral low risk investing appears superior to non-sector neutral low risk investing. An increase of 14% in the information ratio of the sector-neutral strategy was found. We believe this can be explained not only from the low risk anomaly being found in all sectors but also from the fact that the low risk alpha from a given sector tends to show low correlation with the low risk alpha from another sector. The sector-neutral strategies take advantage of this diversification by investing in low risk stocks from all sectors.

Table 2: Alpha and information ratio for two LVMHV strategies, one based on inverse volatility weighted of individual LVMHV sector strategies, which we call sector-neutral, and one applying the LVMHV across the entire stock universe ignoring sectors, which we call non-sector neutral. The beta of both long-short strategies is zero and the volatility is 5% by construction. Jan-1995 to May-2013.

There are important differences in the way the two strategies invest. The sector-neutral LVMHV strategy shows a balanced and comparable exposure to all sectors (not zero because of beta hedging). The non-sector neutral LVMHV strategy comes with a stronger positive bias towards utilities, financials and consumer staples and a negative bias towards information technology.

A number of properties of sector-neutral risk investing are described in the paper. In particular it is shown that the low risk alpha from each sector has low correlation with the alpha from value, from momentum and from small capitalization factors. Thus, sector-neutral low risk alpha adds diversification in equity multi-factor strategies. Sector-neutral low risk investing also comes with almost zero probability of including in the portfolio companies that may subsequently deliverer the poorest performances, e.g. -70% in one month. Such stocks were never found in sector-neutral low risk portfolios in our analysis which started in 1995, at least not in the three months preceding their catastrophic performances. Sector-neutral risk investing offers the same level of liquidity as non-sector neutral investing, and this appears higher than that from value, momentum or small capitalization investing. And the capacity of low risk strategies is not only high because of the higher level of liquidity but also because portfolios do not require high turnover of companies. Indeed, as shown in the paper, the probability that a stock found today in the sector-neutral lowest risk tercile portfolio is still found next month is 94% in developed markets and 94% in emerging markets. The probability that this same stock is found six months later remains high at 83% in developed markets and 80% in emerging markets. 

Low risk investing without interest rate sensitivity

One of the most important benefits of sector-neutral low risk investing over non-sector neutral is the elimination of a negative exposure to interest rate changes. Non-sector neutral strategies, in particular those based on minimum variance algorithms, tend to show a relatively strong negative alpha exposure to interest rate changes. In table 4 we show the alpha from two low risk strategies, conditional to interest rate changes. One strategy is the MSCI World Minimum Volatility index (USD). Note that the algorithm used by MSCI attempts to remove factor exposures other than low risk by imposing a significant number of allocation and factor relative constraints against the MSCI World index. The second, which we call Sector-Neutral Low Risk strategy, is a long-only strategy invested only in the lowest risk stocks of each sector in the MSCI World index, with a simple control of tracking error as an additional means of removing factor exposures against the market capitalization portfolio. The results show a negative exposure of the alpha in the MSCI Minimum Volatility index to interest rate changes with the alpha turning negative when interest rates increase. The alpha of the Sector-Neutral Low Risk strategy is almost insensitive to interest rate changes and remains positive even in raising interest rates.

Table 3: Alpha generated by the MSCI Minimum Volatility index and a Sector-Neutral Low Risk strategy, conditional to monthly interest rate changes. Total returns are gross of management fees, transaction costs and market impact. Jan-1995 to Oct-2014.

Conclusions

The low risk anomaly is not specific of defensive sectors and can also be found in cyclical sectors. We gave strong empirical evidence that the low risk alpha can be found in all activity sectors in both developed and emerging countries. In our paper not only do we give a possible explanation of why the low risk anomaly can be found in all sectors, we also explore some of the properties of sector-neutral low risk investing and compare them to those of non-sector neutral low risk investing. Sector neutral investing appears more efficient than non-sector neutral investing most likely due to a diversification effect arising from the low correlation of the alpha of low risk stocks from different sectors. Liquidity of sector neutral low risk strategies remains as attractive as liquidity of non-sector neutral low risk strategies and superior to the liquidity of value, momentum and small capitalization strategies. One important application of the results of our research is in building low risk strategies without interest rate exposure. Our investment teams have been successfully managing sector neutral low risk equity strategies since April 2011 when they halted minimum variance strategies which in our view suffer not only from interest rate exposure but also a number of other pitfalls.

Related papers by the same author:

Leote de Carvalho, R., X. Lu, and P. Moulin. “Demystifying equity risk-based strategies: An alpha plus beta description.” The Journal of Portfolio Management, Vol. 38, No. 3 (2012), pp: 56-70.

Leote de Carvalho, R., X. Lu, and P. Moulin. “An integrated risk-budgeting approach for multi-strategy equity portfolios.” Journal of Asset Management, Vol. 15, No. 1 (2014), pp: 24-47.

Leote de Carvalho, R., P. Dugnolle, X. Lu, and P. Moulin. “Low-risk anomalies in global fixed income: Evidence from major broad markets”, The Journal of Fixed Income, Vol. 23, No. 4 (2014), pp: 51-70.

References

[1] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2527852

[2] The Global Industry Classification Standard (GICS®) is an industry taxonomy developed by MSCI and Standard & Poor’s (S&P). GICS® is a registered trademark of McGraw-Hill and MSCI Inc.

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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